Opinion | India’s inflation outlook isn’t as benign as it may seem

How would covid, which has driven commodity and oil prices lower and deeply affected the labour market, affect inflation? One would expect inflation to be well within limits, if not actually slip into the deflationary zone. Yet, India’s inflation numbers for June suggest that it has breached the upper tolerance limit of 6% set out by the Reserve Bank of India (RBI).

The reported 6.09% headline inflation is driven by high year-on-year protein inflation, especially meat and fish at 16.22% and pulses at 16.68%, resulting in a food inflation of 7.29%. In June 2020, the prices of pan, tobacco and intoxicants were up 9.7%, and personal care and effects, 12.43%, compared to the same period the previous year.

However, such inflation data appears to present a completely different picture if we study the monthly change in the consumer price index (CPI) over the six-month period of January to June 2020. During this period, food and beverages witnessed a -0.26% inflation rate, with vegetables leading the downward trend at -22.18%. Four items have been above the 6% mark, including meat and fish (12.54%), pulses and products (6.62%), pan, tobacco and intoxicants (6.91%), and personal care and effects (6.11%). Overall CPI headline inflation was just 0.93%.

Has the decline in demand imposed by the lockdown over much of the past six-month period resulted in the fall of inflation below the 2% mark, even as the year-on-year number suggests high inflation? How does one make sense of these differing numbers and what does the future hold for us?

Going by a recent study (https://www.bis.org/publ/bisbull28.pdf) of the impact of covid-19 on inflation risks in 43 countries, including 31 emerging market economies (EMEs), it appears that India’s experience of higher inflation amid covid is actually representative of that of most EMEs. It identifies falling output, oil prices, financial conditions and exchange rates as the variables most likely to impact inflation risks.

Falling output in EMEs, it was found, is associated with an increase in the upside risks of inflation, as borne out by historical data for the past three decades. The impact of falling oil prices on inflation forecasts has been found to be only marginal, with the primary effect being a reduction in an upside inflationary risk, rather than a decline in inflation. Tight financial conditions may have both an accentuating and mitigating effect on inflation. Inflation may get exacerbated if credit-constrained firms increase their markups in order to protect their cash flows; it may get attenuated if such depressed financial conditions affect aggregate demand by lowering investment and hence consumption, and thereby price levels. Finally, the effect of exchange rate volatility is six times more pronounced in EMEs than in advanced economies (AEs), reflecting the higher pass-through of exchange rate to inflation in EMEs.

We may consider supply chain disruptions to be an important factor in shaping inflation in the Indian context. In the agricultural sector, in particular, the lack of a well-developed supply chain, including warehousing facilities, to store and carry produce to markets during covid may have been responsible for the slump in vegetable and egg prices, as also that of the overall food category. With demand falling under India’s lockdown, most firms would have sold their products and services at deep discounts, leading to a steep fall in prices. This may not sustain. Rather, constraints posed by cash flows and the lack of availability of labour and key raw materials may exacerbate supply side pressures, leading to a steep rise in prices in most sectors.

Global oil prices, while currently low, may witness a reversal in trend as the global economy starts moving towards recovery, with tremendous energy and financial resources required for such a revival. Oil and gas companies in March 2020 had announced a 25% cut in aggregate spending due to international price wars and falling demand due to covid-19. With major oil companies abandoning or deferring their major projects in the context of huge losses in the wake of covid, supply-side constraints will bite, pushing oil prices higher in the future.

Bank credit is likely to be constrained during fiscal 2020-21 as banks continue to be risk averse, despite RBI and government measures to ease credit availability. This is reflected in the higher funds maintained by banks with RBI than statutory liquidity ratio rules require, as also the higher credit spreads for most borrowers. An industry report forecast bank credit growth to be at a multi-decadal low of 0-1%. Such lack of credit growth may affect price levels either way. However, the lower resulting investment needs to be balanced against the rise in government spending that will be needed to get the economy back on its growth path. An expanding fiscal deficit would generate inflationary pressures.

However, it is exchange rate depreciation and its high pass-through which is likely to have a significant impact on inflation. The Indian rupee had depreciated 6% by July since the beginning of the year, and this was significantly greater than most other Asian currencies.

While it is the growth consideration that takes centre-stage currently, India may witness another round of stagflation. Policymakers would need to address the multiple explanatory variables of inflation, even as they address the growth challenge.

Tulsi Jayakumar is professor of economics at SP Jain Institute of Management and Research, Mumbai. These are the author’s personal views